Market Volatility Won’t Stay Low for Long

The VIX measures expected risk, out one month. To come up with those expectations about near-term risk levels, market participants tend to look at actual market volatility in recent weeks. The May through July period is historically the quietest period of the year, with a few notable exceptions. With inflation under control and interest rate increases slow and steady, investors have a hard time seeing the catalyst that will change the tone of market.

Beware of the Risks, and Be Prepared

All that said, VIX futures contracts expiring in 2018 are at prices much closer to historically normal levels – which means the VIX could be in the 16% to 17% range or higher in the next 9 to 12 months. Markets are based on perceptions and behavior: The prices for VIX futures expiring in 2018 imply that traders believe today’s low volatility won’t last much longer.

However, advisors can’t rely on the VIX to be a good predictor of future market volatility. It is a better reflection of the current broad equity risk perceptions which can shift quickly as we saw last week. As we saw just two years ago in August 2015, markets can get turbulent very quickly — too quickly for investors to alter their portfolios. An imminent North Korea attack on Guam is an example of a sudden geopolitical event that could rattle equity markets and send stocks spiraling downward. Investors should be aware that low-volatility conditions are not permanent and can change suddenly.

Portfolios need to be structured to prepare for this type of sudden volatility, which is a regular occurrence in markets. A good analogy to the dynamics of markets that we all face are changeable weather conditions. We don’t build our houses for average weather. We build them for the extremes of the climate we live in. And those of us living within two miles of the beach (risk-lovers, some would say), have to build our homes even stronger, and buy costly hurricane insurance to protect against at least a Category 3 “named storm.” Depending on our risk appetite, we can use the same principles in building portfolios consistent with how much turbulence we can tolerate in our investments.

Since the price of volatility is at the lower end of the range now, advisors can take this opportunity to prepare portfolios for sudden, or gradual, changes in volatility. One way is to hedge equities with put option strategies. Another is to shift into lower-risk equity strategies that have less participation in downside equity moves. 

As always, in conditions like this, you might want to consider shifting to strategies that take some equity or credit risk but have higher levels of income as a part of their returns. And, of course, stay diversified across asset classes and global equity markets.

When clients call to express their concerns about volatility returning to the markets, they can rest assured that you are taking all the steps necessary to not only protect their portfolios, but make the most of volatility to help grow their assets.